Tuesday, August 2, 2016

Is The Greenback Set To Tumble?

The dollar is set to fall 5 percent in the next few months, the Federal Reserve isn’t raising interest rates anytime soon and U.S. economic data is only going to get worse.

That’s what Morgan Stanley chief global currency strategist Hans Redeker told clients in a note published Thursday, citing in-house indicators showing U.S. domestic demand is set to fade in the coming months. It didn’t take long for markets to prove him prescient. The greenback fell 1.3 percent Friday, capping its worst week since April, after the Commerce Department said U.S. second-quarter gross domestic product advanced at about half the rate economists had forecast.

“We are quite pessimistic about, first, the outcome of the U.S. economy,” Redeker said in an interview on Bloomberg Television Friday, before the GDP report’s release. “When you look at our internal indicators, which capture domestic demand very well, they are suggesting that the demand strength is going to fade from here.”

The greenback had rallied in recent weeks on mounting speculation the Fed will hike rates in the coming months following better-than-expected data on jobs, retail sales and industrial production. Dollar bulls’ hopes were dampened Wednesday after a lukewarm policy statement from Fed officials that signaled only a gradual pace towards tighter monetary policy. They were dashed after Friday’s GDP print, which showed a 1.2 percent annualized increase in the April-June period, less than the 2.5 percent median forecast of economists surveyed by Bloomberg.

Derivatives traders are now betting there’s only about a 1-in-3 chance of a rate hike this year, down from more than 50 percent at the beginning of the week. July data on payrolls and manufacturing, set for release next week, will give investors a clearer read on the path of Fed policy through the end of the year.

Further dollar strength will be limited as policy divergence between the U.S., Japan and Europe slows, according to Steven Englander, global head of Group-of-10 currency strategy at Citigroup Inc.

“The dollar still benefits when U.S. growth looks OK, but call it a limping divergence trade, not the kind of divergence trade we were talking about last year or the year before,” Englander said Friday on Bloomberg Television.

It has been my contention all year that the Fed won't raise rates as long as global deflation remains the number one concern and so far I've been right on the money on that call.

In my last comment looking at whether US stocks will melt up, I stated that I foresee the US dollar gaining strength in the second half of the year and this will weigh on oil prices (USO), energy (XLE), metals and mining (XME), and gold shares, especially gold miners (GDX) which rallied hard this year. It will also weigh on industrials (XLI) and emerging markets (EEM).

However, I also stated there are clear signs that the US economy is slowing and it's likely the Fed is out of the way for the remainder of the year. If the US economy is slowing and the Fed doesn't raise rates this year, how can the US dollar index (DXY) gain in the second half of the year?

Good question. Let's assume the US dollar continues to weaken, especially relative to the yen but also relative to the euro. How long can this go on before we see another Asian financial crisis? Remember, US dollar weakness comes at the expense of a stronger yen and euro, impacting their exports at a time when they're still grappling with deflation.

That's why when I read nonsense on the endgame for the dollar bull run approaching, I ask myself what exactly that means when Japan is grappling with deflation? US dollar weakness means yen strength, which can't go on forever without Japanese authorities intervening in a massive way.

Also, if the Fed stays put and the US dollar keeps weakening, other central banks are going to continue doing whatever they can to ease the pressure of a strengthening currency.

The key thing to remember when looking at the global economy is the US leads the rest of the world by roughly six months. Bearing this in mind, let's quickly go over two scenarios:

The US economy slows and the Fed stays put. Currency strategists will tell you if the Fed doesn't raise rates, that is bearish for the USD. I say "bullocks" because if the US economy is slowing, the rest of the world fighting deflation is in even bigger trouble. If the Fed stands pat, you will see the Bank of Japan and the ECB pick up their QE/ negative rate activities to fight their deflationary scourge.

The US economy grows and the Fed raises rates. JPMorgan's CEO Jamie Dimon was on CNBC yesterday stating US GDP could rise to 4% under next president and even questioned the accuracy of GDP data stating: “Look, I’m not a buyer of 10-year bonds. I would be a little worried about drastic actions in 10-year bonds.” I have openly disagreed with him on his call for a rout in Treasuries (and have been right mostly because of activities outside the US) but several economists including Leo de Bever would agree with him that GDP isn't a good measure of economic activity because it leaves too much "human capital" out. For argument's sake, let's say the US economy surprises everyone to the upside, then what happens to the US dollar? It will rally hard as the Fed starts raising rates faster than all other central banks.

But when analyzing currency moves, rate differentials and divergence in monetary policy are only part of the story. The other part is positioning, especially positioning data for large leveraged CTAs, global macro funds and huge international trading outfits.

If too many large trading outfits are caught long the USD and they are losing money, then they need to sell their positions and this places more pressure on the greenback. These moves are amplified when traders are taking extreme leverage to go long or short the USD which is why you often see currencies overshoot on the upside or downside.

I asked a buddy of mine who has been trading currencies for over 25 years what his thoughts were on the Morgan Stanley call and here's what he said:

Look if the US economy is slowing the rest of the world will slow or is already slowing too. Last I checked US rates are still positive and the US economy is doing better than the other major economies, so weakness for the US dollar is a capitulation of the long US positions that were built up and should be used as a buying opportunity. Did Morgan Stanley get the move from Oct 2015 to Jan right? There is just too much uncertainty right now (Brexit, US elections, etc.) therefore positions will be paired down which is why the USD is not going up at the moment. In the short-run the USD will likely trade sideways but any shock should bring back USD buying and August tends to be a month of such events.

We shall see what August has in store but the truth is I'm not worried of a major tumble in the US dollar. I'm more worried about the surging yen triggering a crisis, especially another Asian financial crisis which will spread throughout the world and lead to more global deflation.

As far as pensions are concerned, they too need to keep currency risks in mind in this zero and negative interest rate environment. Big swings in any major currency can sock them hard as it did following the Brexit vote. Japan's giant pension fund took big losses during its fiscal year following a sharp surge in the yen.

To hedge or not to hedge currency risk is a big question, especially when billions are on the line. GPIF should have hedged its foreign currency exposure last year but right now, following a big move in the yen, it shouldn't do a thing (or maybe short the yen!).

I personally believe most pensions don't have optimal currency hedging policies. They're either fully-hedged (HOOPP), partially hedged (PSP which is 50% and reviewing its hedging policy) or not hedged (CPPIB). By the way, not hedged for CPPIB is simply going long the USD which is my personal investment philosophy but it's still a strategic position which can tactically hurt you in any given year when the greenback gets clobbered.

The way currencies swing, investors need to take a more tactical hands on approach not just in terms of currency hedging. Following Brexit, it wasn't just a handful of hedge funds that profited, a few large Canadian pensions stepped up their purchases of British real estate and infrastructure and they continue to look for deals.

Foreign investment flows and M&A activity also impact currencies so even if you read hedge funds are raising bearing Pound bets to a record before the Bank of England meeting, don't expect a huge down move following that meeting. The Bank of England might even stay put again but I doubt it.

Also, weak 2Q GDP and poor consumer confidence are not supportive of a Fed rate hike till next year, says Compass Global Markets' Forex SVP, Tony Boyadjian. I agree with him on the Fed staying put but disagree with him that this will cause further US dollar weakness (see my comments above).

In this environment, he's long the USD and gold (GLD). Given my bullish USD views, I wouldn't touch gold, especially after the big run-up this year but I agree with his stance on the greenback which is why I remain short commodity currencies and emerging market stocks (EEM), bonds and currencies.

In terms of risk assets, I continue to recommend the biotech sector (IBB and XBI) and see it continuing to gain in the months ahead heading into the US election and beyond but it will be volatile. If you want to hedge your portfolio, stick to good old US bonds (TLT), the ultimate diversifier in a deflationary world.

And make no mistake, despite talk of a redistributive war on inequality, deflation isn't dead, not by a long shot, which is the biggest reason why I remain long US dollars. In fact, if you want to understand the bigger trends in currencies, just look at which parts of the world are grappling with deflation most and short their currencies on any strength (like the yen below 100 USD).

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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